With more than 115,000 employees on five continents, Germany-based BASF is a major international company. BASF operates in a variety of industries, including agriculture, oil and gas, chemicals, and plastics. In an attempt to increase value, BASF launched Vision 2020, a comprehensive plan that included all functions within the company and challenged and encouraged all employees to act in an entrepreneurial manner. The major financial component of the strategy was that the company expected to earn its weighted average cost of capital, or WACC, plus a premium. So, what exactly is the WACC? The WACC is the minimum return a company needs to earn to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders. In 2017, for example, BASF pegged its cost of capital at 10 percent, the same WACC that it used during 2016, but down slightly from the 11 percent used from 2011 to 2015. In this chapter, we learn how to compute a firms cost of capital and find out what it means to the firm and its investors. We also will learn when to use the firms cost of capital and, perhaps more important, when not to use it. From our chapters on capital budgeting, we know that the discount rate, or required return, on an investment is a critical input. Thus far, however, we havent discussed how to come up with that particular number, so its time now to do so. This chapter brings together many of our earlier discussions dealing with stocks and bonds, capital budgeting, and risk and return. Our goal is to illustrate how firms go about determining the required return on a proposed investment. Understanding required returns is important to everyone because all proposed projects, whether they relate to marketing, management, accounting, or any other area, must offer returns in excess of their required returns to be acceptable.

Objectives:

Determine a firm's cost of equity capital, along with a firm's cost of debt. Also, determine a firm's overall cost of capital and what are some of the pitfalls associated with it & what can be done about them.